The distorting role of subsidies
Subsidies don't make things cheaper. They raise prices and misallocate capital.
The largest flaw in thinking about political economy these days is a lack of appreciation for the importance of price signals and how subsidies distort them.
The use of subsidies as a policy tool is expanding extensively in market economies. Frequently the stated objective is to make the good or service being subsidized – higher education, health insurance premiums, housing, electric vehicles – more affordable.
Subsidizing the purchase of something, however, almost inevitably causes a shift in the demand curve that increases the market clearing price of the thing. More people will pay more for the same quantity of the thing.
Those receiving the subsidy may be made better off net. The subsidy may exceed the higher market clearing price the shift in the demand curve causes. In that sense, a subsidy may make something more affordable for some people.
But overall, subsidies don’t make things cheaper. They make them more expensive.
Subsidizing producers doesn’t necessarily increase prices. But it does distort the allocation of capital.
Price signals tell producers to produce more or less and consumers to consume more or less.
Producer subsidies substitute government money for consumer money. In that way, they substitute the market preferences of politicians for those of consumers.
Producer subsidies reduce the need for producers to raise private capital or satisfy consumers. In other words, they insulate producers to some degree from the discipline of the market. That’s why there are occasionally such spectacular market failures among subsidized enterprises, such as Solyndra.
Even when there is not spectacular market failure, there is a misallocation of capital. What’s happening in U.S. electricity markets offers a good illustration.
Renewable generation, wind and solar, receives heavy producer subsidies. The vulnerability of the grid in many parts of the country indicates that there has been an overinvestment in intermittent renewables and an underinvestment in natural gas generation that can bridge the gap when the wind isn’t blowing or the sun isn’t shining.
An alternative approach to climate change – a carbon tax – would have provided a more orderly expansion of the role of renewables with less risk to reliability than the subsidy approach has produced.
Europe is providing a vivid example of the problem with interfering with the role of price signals. Electricity rates are skyrocketing due to the overreliance on Russia for natural gas, which Russia is aggressively using in an attempt to shake the European commitment to helping Ukraine resist the Russian invasion. At least in the short term, Europe needs to sharply reduce energy consumption.
Where high rates have been allowed to reach consumers, there have been significant reductions in energy use. But, for the most part, European governments are using subsidies and price controls to obtund the high rates. In some areas, consumption has actually gone up.
In a handful of areas, governments pursued the approach that makes the most sense to deal with the crunch. Allow market rates to prevail, providing the maximum inducement to conservation and the provision of new supply. But provide general income support to households of modest means.
This approach, never predominant, is giving way to government rationing, price controls, and windfall profit taxes. That’s a regimen that will delay the market reactions that offer the best and most expeditious way out of the crunch, and will be politically difficult to unwind even if the crunch passes.
Another problem with the subsidy approach is that political processes don’t move at the speed or flexibility of markets.
After Covid shutdowns were lifted, there was a global shortage of computer chips. Congress began working on a bill to subsidize computer chip manufacturing. By the time it was passed, the market had resolved the shortage. Now the industry fears a glut.
Market economies outperform state-controlled economies because price signals more effectively and efficiently allocate capital to maximize consumer satisfaction and preferences. Subsidies interfere with and distort these price signals.
There is a cost to making subsidies such an at-the-ready policy tool.
Reach Robb at firstname.lastname@example.org.